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End of an affair? City of London and EU in bitter acrimony

The global financial crisis has had a seemingly odd impact on relations between the City of London, the United Kingdom and the European Union. Before the crisis, the dominant assumption in Britain was that what was good for the City, Europe's largest financial center, was good for the UK and the rest of Europe. This assumption was not always shared by other EU countries, where suspicions of the financial sector and hostility to "speculators" have often run deep. Since the crisis, Britons have become far more critical of the City. Yet growing British ambivalence about the City has coincided with a mounting political estrangement between the UK and the rest of the EU. What explains this paradox?

Before the financial crisis, the British case for the City of London went something like this: The financial sector is a vital component of the British economy. It accounts for 8 percent of GDP, employs more than 1million people, generates disproportionately large tax receipts for the British government, and contributes to the UK's surplus on trade in services, so helping to offset the country's huge deficit on trade in goods. The City is also a European asset. As the world's largest international financial center, it plays a critical role in supporting the growth of the broader European economy. The City is a ‘European champion' that needs to be treasured every bit as much as German cars or French luxury goods.

Until 2008, the British government exercised huge influence on EU policy towards financial services. It was in the vanguard of countries pushing for the removal of intra-European barriers to trade in financial services – an agenda supported by the City. The financial crisis, however, has altered this triangular dynamic – resulting in a growing estrangement between the EU and the City, the British government and the City, and the UK and the EU.

The greatest rift has unquestionably been between continental Europe and the City. Across Europe, politicians blame the global financial crisis on regulatory failures in the Anglo-American world. The eurozone crisis has reinforced continental suspicions of unregulated Anglo-Saxon finance, with the City widely seen as a nest of speculators that poses a threat to the very survival of the eurozone. For many European leaders, therefore, the task facing policymakers is straightforward: Ensure that the UK is made to regulate the City to continental European standards. As French President Nicolas Sarkozy recently remarked, the eurozone cannot put up with a larger version of the Cayman Islands on its own doorstep.

To the UK, continental political rhetoric has seemed distinctly slanted. Official reports into the crisis have owned up to British failings and questioned many long-held assumptions – from the "social utility" of certain financial activities to the desirability of an outsized financial sector. But many of the factors that contributed to the global financial crisis – excess leverage, poor risk management and inadequate supervision – were just as common in continental Europe as in the UK. Besides, the popular continental narrative neglects how much the UK has now changed: It has abandoned "light touch" regulation of its own will, going much further in some regulatory areas than other EU states are prepared to contemplate.

The City of London, then, has faced a regulatory crackdown from two distinct directions. At home, the British regulatory authorities have made it clear that they will force UK banks to hold more capital than actually required under international or EU standards. The government, meanwhile, has overhauled the supervisory architecture for financial services and has indicated that it will implement the proposals of the Independent Commission on Banking, chaired by Sir John Vickers, which will effectively separate the retail and investment banking arms of UK banks. These far-reaching changes so far have no counterpart in any other EU member-state.

Across the channel, the City has faced a slew of regulatory and other initiatives originating from the EU. Close to 50 measures affecting financial services have been proposed since 2008 or are in the EU legislative pipeline. Some are designed to implement commitments entered into by the UK in the G20. But others are over and above such commitments, and have been proposed under pressure from countries such as France and Germany or EU bodies such as the European Parliament. As the focus of many EU measures has moved from lifting barriers to trade to imposing regulatory costs, the City has become more euroskeptic.

Britain realizes that it has a comparative advantage in a sector that poses large costs on the rest of society when things go wrong – as they did, for example, at the Royal Bank of Scotland, a disastrously-run institution that had to be bailed out at vast expense by British taxpayers. Broadly speaking, therefore, the British government's current policy objective is to protect London's status as a financial center while trying to reduce the contingent liabilities that its activities potentially impose on the taxpayer. The financial sector is as unpopular in the UK as it is elsewhere, and relations between the government and the City are less cosy than they used to be. But the government does not want business to migrate elsewhere – with the attendant loss of jobs and tax revenue.

Other EU governments are less sensitive to London's concerns. They pay lip service to the City being a "European asset." But many resent the fact that Europe's largest financial center is located outside the eurozone and would like more business to be conducted in centers like Paris and Frankfurt. Most are wary of hedge funds – mainly based in London – and suspicious of speculative activities such as short-selling. And few anticipate having a stake in London's future as a financial center. In most EU countries, the prevailing attitude towards London veers between indifference and hostility.

The upshot is that the UK has often appeared isolated, fighting rear-guard actions to protect London from initiatives emanating from the EU – such as a proposed financial-transactions tax which would disproportionately hit the City and the UK.

EU measures affecting London have become mixed up with British domestic politics. The largest of the UK's governing coalition, the Conservative Party, is increasingly ambivalent about British membership in the EU: A sizeable number of its parliamentarians are pushing for a referendum on EU membership and would campaign for a British withdrawal. It was to placate euroskeptics in his own party that Prime Minister David Cameron sought safeguards for the City of London at a December EU summit that was discussing a very different topic – how to save the euro.

The outcome: European leaders declined to provide the City with any such safeguards; Cameron vetoed a proposed EU treaty to reform the governance of the eurozone; and British euroskeptics cheered as the country's relations with the rest of the EU sank to a historic low.

The UK now finds itself more isolated inside the EU than it has ever been. Seen from the continent, the UK chose to subordinate the fate of the eurozone to the interests of the City – a move that many EU countries may find hard to forgive or forget. The UK may now find it harder to prevent or amend EU measures that do not take the City's interests into account. The question is whether this pushes the UK ever closer to the EU's exit door.

“Flirting with Russia is guaranteed to antagonize the rest of the eurozone,” Mr. Tilford of the CER said. “It will make it harder for those in Germany who were arguing for a more conciliatory line toward Greece to keep it.”

“The likeliest outcome is that they will not agree to roll over the sanctions now and they will put off a decision until the last possible moment before the sanctions expire,” said Ian Bond of the CER.